Phillips Edison & Company, Inc. (PECO) Earnings Call Transcript & Summary

Get started here. Hi, everybody. This is PECO's roundtable presentation. I'm Lizzy Doykan. I work with Jeff Spector in covering the retail REITs at Bank of America. With us today, we have Jeff Edison, CEO; Devin Murphy, President and [indiscernible] of Investor Relations at PECO. So I'm going to turn it off to the team to start with any opening remarks. Just kind of give us an overview of the state of the business today, maybe any operating updates that you've come to the conference with this, and then we can open it up to Q&A, and please jump in at any time with any questions. So with that, I'll turn it over to Jeff.

Thank you, Lizzy and thanks, everybody, for being here. It's a stand-up room only, you can see with this huge audience. But we do thank you guys for being here. We are in an environment today in our business where the operating side is as strong as it's been in a long time. We are at record occupancy levels, we're at record [indiscernible] numbers. And we're in an environment that on the operating side is very strong. We feel that like this is not just a short-term like slip. This is an operating environment that is being driven by really a lack of new supply in our space for a sustained period of time. And that lack of new supply with strong retailer demand is allowing us to get really record levels in terms of occupancy and rent spreads. So we're very positive on the operating side. On the -- with what's happened in the interest rate market, the acquisition side is a little less stable or defined. We have seen the first half of this year a very muted level of acquisition opportunities. And what was difficult for us was to be very disciplined in not buying anything during the first half as the market was going to -- moving towards understanding where was pricing in this new interest rate environment. We have seen some change in that market over the last 6 to 8 weeks. We've seen, I think, a number of projects that we feel really good about have coming to market that we've been awarded that we're excited about. So we think that the market is starting to show signs of accepting the new pricing rates, which are probably -- we -- at the end of last year came and a little before that, we changed our unlevered IRR target from 8% to 9%, just given what was happening with interest rates, that made it tougher to buy. Part of the reason we had a slow acquisition pace during the first half of the year. The market is starting to get there on that. And we're optimistic. We told at the earnings last year -- or last month or -- last quarter, we confirmed our target of $200 million to $300 million of acquisitions this year. We were pushing to get there. We're much more comfortable with those numbers today than we were even 6 weeks ago. So the market is moving where we feel positive about that. So we think our external engine of growth is there as well as the internal engine that we talked about on the operating side. So we're -- I would say we're in a spot where we feel really good about those pieces of our business strategy. And we've -- when we came public, we had a very targeted focus on grocery-anchored shopping centers. We continue to keep that focus, and we are optimistic that we're in a really good space to be able to show significant growth and we're excited about it.

Great. Thank you. I'd like to touch on the operating side first. So in terms of organic growth, can we discuss what you see as the building blocks for your long-term same-center NOI target of 3% to 4%? How high can you really take occupancy? You have some of the highest rates in the space and can we continue to expect new leasing spreads in that 20% to 30% range? So we could just go through the building blocks of that growth.

So our view is we have a long-term sustainable same-store NOI growth of 3% to 4%. The building blocks of that are, we believe that we'll get 125 -- 150 basis points, excuse me, of NOI growth from leasing spreads. We'll get 100 basis points from contractual rent bumps that are embedded in the existing leases. That gets you to 2.5%. And then the last component of that growth is our re-development activity, which will deliver 125 basis points. So that gets you to the high end of that 3% to 4% range. And that's assuming no contribution from occupancy growth. Now we are almost 98% leased at the portfolio level. In line is just under 95% leased. We think we can still take in line up another 100 to 200 basis points here. So that will be another 100 to 125 basis points increase in same-store NOI in the near term as we capture that occupancy uplift. And then obviously, we think we're done. The reason we're optimistic that the kind of spreads that we're enjoying. So in the second quarter, our in-line re-leasing spreads were almost 18%, just under 18%. That has been trending upward for the last several years. Historically in this business, we were getting 8% to 10% re-leasing spreads in line. Last year, it was 14%, second quarter, it was almost 18%. That is continuing to improve, and there's a simple reason for that, which is the point Jeff made on supply. We're seeing very little supply added in this business. And if you look across the U.S., the occupancy level of open air gross rent of retail is 94%. So there's very little inventory available for the retailers to lease. And that the demand from the retailers in terms of the kind of properties that we own 100% suburban and 50% in the Sunbelt is being driven by a number of macro trends. Suburbanization, the move to the suburbs, work from home, people spending more time in the suburbs, migration to the Sunbelt and then shrinkage in the urban environment is forcing the retailers to look more at the suburban markets for their growth. And so we're getting the benefit of that retailer demand that we've not seen historically. And then in addition to just overall retailer demand being driven by those macro trends, there are emerging verticals in our portfolio that we call medical retail, we call it Medtail. And if you look at our portfolio, over 5 years ago, we basically had no exposure to that tenant use. Today, it's high single digits of our ABR. It's about 20% of our portfolio. So we see that demand cohort growing. So this combination of limited supply, strong demand for the kind of assets that we own and operate makes us confident that we'll continue to be able to enjoy the kind of same-store NOI growth that we're currently delivering. And for this year, we think that number will be north of 4%. The midpoint of our guidance is north of 4%, which is again above the high end of the range that we believe is achievable on a long-term basis.

The only thing I would add there on, the supply side is online was going to grow to the sky. And the growth of online is significantly reduced -- online retail has significantly reduced. That was another threat to supply. And that is another part of the supply that is reduced. And almost everyone in the online-only business is looking for bricks and mortar as part of their strategy, again, adding to the demand for space. So you've got this is decreasing amount of supply of online retail sales, so that is actually part of what's helped us to have the kind of operating environment we are in.

When it comes to your in-line space, can you discuss the state of the health of your neighbors? How do we think about the 10% occupancy cost ratio there for the in-line retailers going forward? And should we be concerned with the categories, because you have such low exposure to the more distressed categories that we're seeing?

Yes. If you look historically, Lizzy, I know there is a perspective that 26% of our ABR comes from what we call local neighbors. So those are smaller operators that own less than 3 locations in their portfolio. However, their highly successful entrepreneurs, they have strong credit and they bring a uniqueness to the merchandise mix that we like. And if you look at our historical performance with that type of tenant, it's been very good. If you look at the amount of occupancy we lost during COVID, it was lower than any of our public peers. And we recovered our occupancy losses faster than any of our public peers. So again, we are very confident in the credit quality of our neighbors. And I think in terms of a perspective on the viability of us continuing to push rents at the level we're at, I mean, we would say, look at our renewal rate. In the second quarter, our renewal rate was 94%, and that's in the face of the kind of spreads we're getting. So our tenants clearly believe that they can continue to pay the kind of rents that we're demanding and stay in this space. And if you look at that retention rate over time, again, it's a positive trend line. So we're pretty optimistic that credit is not a big concern for us given our business model. If you look at the exposure that we had to Bed Bath and Park City, in the aggregate, it was less than 50 basis points. And we don't have exposure of any meaningful level to any of the other retailers that are on people's watch list. If you look at our watch list, our top 10 tenants on the watch list represent less than 2% of our ABR. And the one tenant on that, that people are particularly worried about is JoAnn Fabrics, we have a de minimis amount of exposure to JoAnn is circa 30 basis points. So we have very limited exposure to big box retailer, where [indiscernible] to occur, a; and then b, we're extremely well diversified. If you look outside of grocers, our single largest tenant ex the grocery is T.J. Maxx, 140 basis points of our ABR. So credit concern is definitely not on our top list of concerns.

And outside of the more watch list tenants, recently, Kroger and Albertsons did announce that they were going to sell off over 400 stores. So just wanted to gather your thoughts there, what is PECO's exposure and maybe the thoughts on the deal going through?

Great. Let me start with the deal going through. Right now, Albertsons is trading at about a 13% discount to strike price. So the market is saying they -- that's up from a 20% discount that they have been trading. So the market is kind of saying that it's the C&S announcement is helpful, but certainly does not give certainty. And JPMorgan came out this week, and their lead was that it was a 5% chance of happening and now they think it's a 20% chance of happening. So it's -- whether or not the merger happens or not is still very, very questionable like there's certainly a big risk that it does not happen. We've looked at it from the very beginning when they first made the announcement. We have somewhere in the low 30s in terms of exposure centers that where there's a sister store within 3 miles of an existing store that we have. And so that's our range of exposure. That's with -- we have 93 across the Albertsons and Kroger banners in our store, we are Kroger's largest landlord. So we are engaged in this thought process of what could happen. The original plan when we had that 33, that now is 27 after the announcement, because of some of the positions they've taken where they're going to trade out stores. So that's generally a positive that there's less exposure. We think our real exposure is somewhere between 5 and 8 stores that could stay under the C&S banner or move under the C&S banner versus the Kroger or Albertsons' banner. They will use the banners that part of the deal is that C&S will take the banners over that Safeway and Albertsons had. So there is place that they will probably be operating as those stores, which we think is a significant improvement from Propco, which was their last plan, which -- and Propco was going to be -- they're going to take all these stores. They're going to put them in a pool and Propco was going to be run by some kind of company put together of Albertsons employees. That -- so this is a significant improvement from that. C&S, who is the buying partner, a 100-year-old company, the largest wholesaler in the country. So they are a real grocery operator, but they've been on the wholesale side more than they've been on the operating side. So that's, I think, the question out there for the 5 to 7 properties that might go under that banner. But as we say that, the other properties that we've got that are under that banner, which if we say it's 10 at the sort of the high end of the range, you've got 83 properties that are now worth more because you've got -- one, you've got a stronger grocer running them. The Albertsons, which is up, I think, 32 -- 31 of those stores. They're now not run by a private equity firm, but they're run by one of the best operators in world or certainly in the country, in Kroger. So we're going to see significant improvement in those -- the running of those stores. So that generally is the reason that we're positive about the transaction. Even though we do still are recognizing that it still has a fairly low probability of getting through the FTC without some significant changes.

Turning to external growth. In the beginning, you did comment you all are seeing some signs of new pricing, some activity, and you reaffirmed $200 million to $300 million of acquisitions this year, that's pretty in line with last year. Are you seeing just to clarify changes in pricing? If you can kind of give us a gauge of what you're seeing out in the market today? We know you did close on Lake Pointe Market. So what would you need to see in the market to get additional deals done in the second half?

So as the interest rate started to rise, we made the decision to change our targeted unlevered IRR from an 8% to 9%. We think that, that gives you some measure of the increase in the cost of capital given the dramatic increases in interest rates. So we -- the hurdle for us for the first half of the year and going forward is finding opportunities where we can get to that level of unlevered IRR and with given our sort of strict underwriting that we do, which basically does not assume any kind of cap rate compression or excessive kind of assumptions. So we feel really good about our underwriting. We feel like -- but getting to 9% is not an easy thing for grocery-anchored shopping centers. And particularly with the #1 or #2 grocer in it, we're doing really good sales. So we [indiscernible] pretty hard. And I would say that our feeling is that, that the move in pricing has moved from sort of a mid-5s cap rate to -- well, we've moved 100 basis points in our IRR and really our IRR buyers that always translates into a cap rate, but that changes the cap rates from 5.5% to 6.25% to 6.5%. And so that's the movement we've seen. And that movement gives us -- I mean as the market accepts that movement, because there are a lot of sellers, who have not accepted that change, that's going to -- that will be the sort of governor in terms of how much we can buy, how much the market really accepts that change.

Yes. Lizzy, if you look at the 5 assets we've closed on year-to-date, it's circa $92 million of acquisition volume and the weighted average cap rate was 6.3%, which is pretty consistent with what the cap rate was on the acquisitions we accomplished in 2022. So we think the cap rate movement occurred pre January of this year, because interest rates started moving up in February of last year. Cap rate movement really occurred back half of last year. And it's basically moderated and basically stabilized. What we're seeing is more supply coming in, in the market, right? Now the point Jeff was making, sellers have begun to accept the fact that this asset back in 2021 was a 5.5% cap asset, is no longer a 5.5% cap asset. It's now a 6.25% cap asset. And given where rates seem to have stabilized and the fact that this is not a temporary movement in cap rates, they're like this is an asset we want to sell, so they're fundamentally capitulating, if you will, that asset pricing has moved to where we're accepting of that reality, and therefore, we're going to transact on the asset.

And on Lake Pointe Market, specifically, so that's a grocery-anchored center that PECO acquired post quarter, at what pricing did that close at? And is that reflective of the conditions you're speaking to?

It traded slightly higher because it was a shadow-anchored asset, not -- we didn't get the revenue from the Albertsons that was there. And so it traded -- I think it was in the 7% -- in the like the low 7% cap rate, but it had an unlevered IRR well above 9%. It was in the 10% kind of range. So we -- I mean, I think there's always a low trade up in these deals back and forth. But so I would say 7% is we got compensated for the shadow-anchored part of it. But -- and with the anchor, it would have been a 6% to 6.3% kind of the yield to get to the returns that we were talking about.

And just on that topic, we're seeing a lot more public-to-public consolidation within the strip space. It's probably the most topical thing right now. What are your thoughts on Kimco's with RPT? And did that make the PECO team change your approach in terms of discipline, in terms of quality and what is out there? One of your peers had commented that we're actually seeing more of a limitation on public to public. So do you think we'll see more of this, general thoughts?

Yes. So having been -- having done this for a long time, we bought a number of portfolios over time. And the complication with portfolios is you don't get what you want. And so we have been pretty disciplined, not very disciplined actually in buying individual assets versus buying portfolios, because as an example, when we looked at RPT, we would have had to sell off 75% to 80% of the properties, because there is only a small part that actually met what we do in the grocery-anchored REIT size -- grocery-anchored shopping center with the #1 or #2 grocers. So it's a very different play for us. So -- and Kimco is in the power business. So they fit with them much better than they would fit with our strategy. And we're -- we look at basically everything that comes into the market. And -- but I would say that the chances of us getting to one of those larger transactions, it would be difficult, because we are very particular about what properties we want in our portfolio. And when we buy them individually, we just feel more comfortable that we've done the underwriting. We know we're getting what we're getting. We're not compromising on what we buy. And that -- it's worked for us for a long time, and we think that, that does build the strongest long-term portfolio. But I say that. And yes, we will look at those transactions at the right pricing, right timing. But I wouldn't count on us being one of the real active in that part of the market.

I mean, Lizzy, we have a cost of capital that would allow us to be a buyer in a [indiscernible]. But to Jeff's point, we have a unique business strategy, and there are very few public companies that have a business strategy that aligns with us. So there are not a lot of potential merger candidates for us in the public market. So that's why it's -- we're unlikely to be an acquirer that way. The thing that we think may be underappreciated is there are 5,800 shopping centers in the U.S. that are anchored by the 1 or 2 grocer in the market and have the demos that we are looking for when we acquire an asset. So the buyer -- the buying pool that we can access is deep and there's a lot of assets that we can acquire that meet our objectives. And we believe we'll get a better return on an asset by asset acquisition strategy than we will, if we migrate to a corporate or portfolio acquisition strategy. And we think that given how low we levered our balance sheet is at now circa 5x debt to EBITDA, we have plenty of dry powder to acquire. And if the market shows us assets that allow us to hit our 9% unlevered, we'll be -- we could buy $500 million, $600 million of assets, which as a percentage of our market cap would be meaningful. So we're confident we can grow the company at a very attractive level on an asset-by-asset basis.

I guess turning to the balance sheet then. So you recently -- you extended the maturities on the $475 million of term loans, and now you have no meaningful maturities until 2027. But those underlying swaps on the 2024 maturities will expire -- they will expire in 2024. So how are you going to address those swaps when they roll off?

So our view is that our target on floating rate debt is approximately 10%. We recognize that we're currently above that level. Our view of the debt markets right now is that spreads are at historically wide levels given the uncertainty in the underlying index. Investors don't know where the index is going, so they're demanding wider spread on leverage. So we will have to do a secured fixed -- not a secured, a fixed rate financing in the next 12 months, Lizzy take our floating rate debt down to our targeted levels, which we expect to do. Our hope is that we will see spreads grind in a little bit here as there's more perspective on where the index is going. And therefore, we'll be able to finance at a more attractive rate.

And then when it comes to earnings growth, so you mentioned you can produce mid- to high single-digit FFO growth beyond 2023. And if you could speak more to the pieces of getting to that growth, maybe going off of how this year will end and without giving hints into next year, how we should see that progress?

Look, the issue that we and a lot of REITs have is the incremental increase in interest rates. And if you look at what the cost of debt for us in 2023, is as a metric, it's $0.14. So it's basically a 7% headwind in growth. Despite that 7% headwind in growth, we'll still put up positive FFO growth in the low single digits in 2023 with that headwind. That headwind is going to moderate in '24 and '25 and then ultimately go away. So our view is that mid- to high single digit is a longer-term run rate. It will be less than that in the near term given that debt headwind. But the components of it are 3%, 4% NOI growth with operating leverage that translates into circa 5.5% growth internal. And then we add to that, the growth we can get from acquisitions to the external growth. So those are the building blocks of the growth profile.

If I go back to acquisition targets, how does PECO really define quality? And I know it's going to differ by REIT. But how do you define that?

I'll define always A+ quality.

Yes. I mean you often talk about the SOAR method in approaching what makes sense for your portfolio. So given there's so much opportunity out there, how does it -- what does it really come down to?

Yes. So I think the simplest way to think about it is when if you live -- if you don't live in New York, you live in the burbs, you're on a Saturday when you wake up and you've got to do your necessity-based thing. I got to go to grocery. I got to get my nails done. I got to get my haircut. I got to, I want to work out. I want to get a smoothy. Where do you go? And what the average American does is they go to their Kroger. They actually go and they do their other things first and then they end up with their Kroger and they come home with having done that. And they do that within 3 miles of their house. And what we try and do is provide the best merchandise center with that #1 or 2 grocer close to your home. And that is a very different shopping experience than when you go to Home Depot for your home project or when you go to get a big screen TV, like those -- that's a different shopping experience. Our focus is on that necessity-based focus of 3 miles from your house with the right grocer that you'll go to on average 1.7 times a week. That's our strategy. That's been our focus, and we think that, that is what differentiates us and is what's been able to produce the results that we've been able to produce.

And we view quality as where do retailers want to lease space because at the end of the day, they are the customer and where the customer wants to be should define quality. And as we look at our portfolio, we have a 98% occupancy, highest in the business. We have a 94% retention rate among our neighbors tenants, we call tenants neighbors. So in our view, the customer is giving us an A+ on the quality of the assets that we own because we have the highest level of occupancy. We have the highest level of retention. So our customers are extremely pleased with the product that we're delivering, which we would view as being high quality.

When it -- just turning to supply now, because this is -- now we're seeing the space just marks by years of supply being at its lowest. When do you believe the development of new shopping centers might start? And can you just characterize what you're seeing in your own markets today?

Sure. I'll move both that -- so if you look at what we bought the first half there, we bought at $225 a foot, that's what it costs, all in, including the land. To replace that is probably $450. Rents in our mind to justify new development, new supply, would have to almost double to what they are today in order to justify the risk of new development. So our feeling is that, that supply side is, it's a ways from starting. It's certainly -- we know that it's not happening right now, which means at the earliest, it's 2 to 3 years out if somebody tries to start a development project today that we would know about, because we would know the anchor and where they were going and that's easily a 2, but probably a 3-year before they're actually a competitor of yours. And we're not seeing any of that right now. So you look at it and you say, we do have -- we have a decent runway. And that's -- we feel pretty good about that.

All right. Anything I missed? Any questions out in the audience?

What's the competition like from the [indiscernible] obviously, you guys have proven your model really well. Our interest rates keeping buyers away. It's [indiscernible], more competitive for the last 3 years?

Great question. I would say that some parts are stronger and some parts are weaker. Grocery-anchored shopping centers have become more popular. I mean we've been doing it for 30 years. So we're not new into the business, and we've seen the cycles go up and down for grocery-anchored shops. There is more interest in grocery-anchored shopping centers today than there was 3 years ago. So I would say that, that is a -- it brings more competitors into it. The leverage buyers used to be a fairly significant player in our market as well as the tax-free exchange buyer. Both of those are very meaningful. If you're having to borrow a significant amount of money, I mean the -- a lot of that they borrowed was from the regional banks, who are pulling back dramatically in terms of their allocation to new loans for buyers. So that part is less. The leverage buyer is less. The institutional buyer is probably the same, maybe even a little bit more, but it's early days for them. They're concerned. They don't -- they're not comfortable with where the pricing is. They don't know where it's going to end up. So they're not -- we're not seeing them show up. We anticipate them showing up, and there are certainly conversations about them showing up. And those are 2 biggest competitors when we're buying properties. So one side is really gone away that tax rate change and the leverage buyer. But these super guys are there. And on specific assets there, they will pay a lot -- they're willing to pay a lot more than we will for certain properties.

All right. So we're actually out of time. But before we end, I'd like to end with 3 rapid fire questions, no long answers. So first question on Fed. Do you believe the Fed is [indiscernible]? Yes or no? Do you expect the Fed to cut rates in 2024? Yes or no?

No and no.

Number two, do you believe real estate transactions will meaningfully pick up by the fourth quarter of 2023, the first half of '24 or the second half of '24?

First half of '24, meaningfully yes.

And last, are you using AI today to help you run your business? Yes or no? Do you plan to ramp up spending on AI over the next year? Yes or no?

Yes and yes.

All right. Thank you very much.

Thanks, Lizzy. Thanks everybody.

Thanks, Lizzy.